Investors Need to Know Truth About Risk, Zvi Bodie Writes in Investment News

in Finance, Risk Management
May 27th, 2010

With co-author Richard Fullmer, Bodie responds to SEC’s new education Web site

 

Zvi BodieWorld-renowned investment scholar Zvi Bodie, the Norman and Adele Barron Professor of Management at Boston University, has published an article in Investment News reiterating his long-held theory that investors need to better understand risk.  Along with co-author Richard K. Fullmer, Bodie writes,

A few months ago, the Securities and Exchange Commission unveiled Investor.gov, a website devoted exclusively to investor education.

A press release quoted SEC Chairman Mary Schapiro as saying, “Investing information is available from thousands of online resources — some good, some not so good. Through Investor.gov, we are adding our own online voice to provide investors with unbiased and factual investing information.”

This effort is to be applauded. With the burden of funding retirement rapidly moving from institutions to individuals, investor education is needed now more than ever.

It is the presence of two key adjectives in Ms. Schapiro’s statement that makes this initiative so momentous: “unbiased” and “factual.” These aren’t words to throw about lightly.

Having spent the bulk of our careers studying financial economics in an effort to differentiate between fact and fiction, we were inspired by these words to reflect on the principles that should govern any program of investor education. Without question, the first guiding principle must be the doctrine of “primum non nocere”: First, do no harm.

Strictly speaking, unbiased and factual information is that which is 1) fairly presented without selective omission, and 2) supported by science and empirical evidence.

Guidance that violates the first part of this definition falls into the “not so good” category (to quote Ms. Schapiro). Guidance that violates the second part is just plain wrong….

The following are four examples of misleading statements found repeatedly on investor education sites:

  1. The risk of investing in risky assets decreases with the length of the holding period, and therefore, stocks are safer in the long run. Financial economists have long shown this to be a fallacy. That this may not be immediately intuitive is no excuse. Risky assets remain risky, no matter how long one holds them. Time doesn’t diversify risk.
  2. Stocks are effective as a hedge against inflation. The truth is that stock returns are largely uncorrelated with inflation. The safest and most effective hedges against inflation are inflation-indexed bonds backed by the federal government. Of course, the expected return on these bonds is relatively low — a trade-off for their safety.
  3. This tool computes the “probability of success” for your financial plan and should guide your investment decision making. This is a dangerous half-truth that confuses the science of probability measurement with the science of risk measurement. The probability of anything is never a complete measure of its risk. Risk measurement is concerned not only with the probability of events but also with the consequences of those events. Using the probability of success as a risk measure can mislead investors into using an overly aggressive investment portfolio, because the severity of the downside goes unaccounted for.
  4. Retirees need a significant allocation to stocks in the retirement years to provide growth in order to offset inflation and address longevity risk (the risk of outliving the portfolio). This is true only in the absurd. It is analogous to saying that those unable to pay back a debt “need” to visit a casino to “address” the risk of defaulting. The better advice is not to get oneself into such a predicament in the first place. The suggestion that people need to place their financial futures at risk is irresponsible. Risk taking is a choice, not a requirement.

Notably, each of these items errs on the side of excessive risk taking.

Is it merely coincidental that many investors have suffered unexpectedly large losses in their retirement accounts, just when they could scarcely afford to bear these losses, or did the guidance they received make it inevitable?

By no means are we saying that investors should shun stocks or other risky investments.

We are just saying that investors (and practitioners) need to understand the true nature of the risks involved in investing and financial planning. Only then can wise decisions take place.

The central thesis of investor education shouldn’t be based on the principle of taking risk first and worrying about the consequences later. Rather, it should be based on the principle of safety first.

Start by educating consumers on what is possible with minimal risk taking, such as with a diversified portfolio of guaranteed, inflation-protected income annuities. Then proceed to discuss the risk/reward trade-off of other investment alternatives — and be sure to use a scientifically sound risk measure that accounts holistically for both its probability and its severity.

From the article “Investors need to know the true nature of risk,” by Richard K. Fullmer and Zvi Bodie, Investment News, February 7, 2010.